Inflation refers to an increase in the price of goods and services. This happens when too much currency is in circulation, causing money to lose its value. On the other hand, deflation refers to an increase in the value of a currency and a corresponding dip in the price of goods and services. Deflation is usually caused by a decrease in the supply of the currency.
Some inflation is good — it keeps the economy growing by encouraging people to spend more. However, it becomes an issue when the prices rise faster than our salaries. Currently, inflation is rising at alarming rates. In the US, inflation surged to 8.5 percent in March, touching a four-decade high. In India, wholesale price inflation (WPI) came in at 14.5 percent, the second-highest since 2012.
It has caused several individuals to invest in cryptocurrencies, which are being touted as a hedge against inflation. Many of these cryptos have appreciated significantly in value over the last couple of years. With good returns, the value of your investment increases over time, helping you effectively combat the rising prices caused due to inflation.
However, even cryptocurrencies can be inflationary and deflationary in nature. Some have an unlimited supply of tokens, making them inflationary while others have fixed number of tokens in circulation, making them deflationary.
A cryptocurrency is inflationary when the number of its tokens in circulation is on the rise. New tokens are introduced to the network through mining, staking, etc. As the supply of the token increases, its value decreases. This means that you will have to spend more and more tokens to buy a particular thing over time.
For example, Dogecoin is an inflationary asset — one of its creators had abolished a hard cap of 100 billion DOGE in 2014 to ensure the asset had an unlimited supply. This means the supply could outpace demand, decreasing the value of every Dogecoin.
Also Read: What happens after all Bitcoins are mined and network reaches its final cap of 21 million?
Then there are coins like Bitcoin — which is inflationary but to a limit. What does that mean? To begin with, Bitcoin has a hard cap of 21 million. Once this limit is reached, nobody will be able to mine Bitcoin anymore. When that happens, it will become a deflationary cryptocurrency. However, the network is not expected to reach this threshold until the next century.
Until then, Bitcoin also employs a process known as halving to slow inflation. It cuts the number of bitcoins that can be mined and put into circulation once every four years. And even though 19 million bitcoins have already been mined, reaching 21 million will take a century because the mining rewards gradually drop.
In 2016, the mining reward was 12.50 bitcoins. Then, it dropped to 6.25 in 2020 and will drop to 3.125 bitcoin in 2024. This is known as bitcoin halving. It is a measure to decrease the number of coins entering circulation.
With deflationary cryptocurrencies, the supply of coins will decrease over time instead of increasing. This means the value of each coin will rise if the demand remains consistent. However, different projects employ different deflationary measures.
For instance, crypto exchange Binance destroys some of its Binance Coins (BNBs) every quarter to reduce its supply. On the other hand, some cryptos work like central banks — they employ inflationary and deflationary measures to keep the value in check. An example is the TerraUSD (UST) stablecoin. Its network — the Terra Network — mints and burns (destroys) tokens, so its price remains constant at $1.
Then there is Ethereum. Its native token, ether, was once purely an inflationary coin. However, an update in August 2021 mandated that some ethers be burned when the network activity rises to make the coin deflationary. As per the tracking website Watch the Burn, more than 1.7 million ether coins worth upwards of $4.5 billion have been burned.
Ripple chose a different way to keep its token (XRP) deflationary. First, it released 100 billion XRPs together. Then, in 2017, Ripple locked away 55 million of these coins and releases them periodically to maintain liquidity.
Further, every time you make a transaction using XRP, you pay a tiny transaction fee which is then burned to maintain the coin’s deflationary nature.